Earnings: Where the Q2 Surprises Could Be

Analysts see potential for a number of unexpected positive results in financial services. But the unemployment picture can't be ignored

By David Bogoslaw

The pullback in equity indexes on July 2 in response to the larger-than-expected drop in June nonfarm payrolls shouldn't have been a surprise, as light preholiday trading probably exacerbated the data-driven sell-off. But the disheartening employment snapshot doesn't necessarily bode any worse for second-quarter corporate earnings than what most investment strategists and economists were already anticipating.

Earnings for the companies in the Standard & Poor's 500-stock index are expected to be down 35.5% in the second quarter from a year earlier, according to the July 2 report by the Thomson Reuters (TRI) Proprietary Research Group. Earnings season is scheduled to start with Alcoa (AA) reporting results on July 8. The biggest year-over-year declines in profitability—a 79% plunge—is expected in the materials sector, which shouldn't surprise anyone who has followed the deterioration in the housing and commercial real estate markets.

Thomson Reuters' highest earnings forecasts are for a 2% decline for the health-care sector and a 6% drop for consumer-staples companies. A 29% decline is projected for consumer-discretionary companies.

The fact that 467,000 jobs were lost in June—100,000 more than the market expected and a substantially bigger decline than in May—disappointed those who assumed the pattern of diminishing job losses since the January peak would continue. But Art Hogan, chief market analyst at Jefferies & Co. (JEF) in Boston, says the huge drop from 741,000 jobs lost in January to 345,000 in May "set us up for disappointment."

It doesn't surprise Hogan that companies are reluctant to hire new workers until they see significant improvement in the economy. But he doesn't see a clear tie between the magnitude of continuing job losses and earnings. "It's anybody's guess whether we're down 34% year over year for the second quarter or 24%. I think we're positioned to have some upside surprises," though that may not be enough to ensure further upside to stock prices, he says.

Setting the Second-Half Bar Low

The near-absence of pre-announcements from companies over the last three or four weeks suggests the results will be fairly good, says Phil Orlando, chief equity market strategist at Federated Investors (FII) in New York. But he says he's not expecting much positive guidance for future quarters from corporate managers. "There's no reason for them to do so" in the current environment, he says. "It's better to set the bar as low as you possibly can and manufacture a positive upside surprise in the third or fourth quarter."

Reporting higher profits later this year shouldn't be too hard if the recession is about to end and positive economic growth returns in the third quarter, as Federated believes will be the case.

Mickey Cargile, managing partner at WNB Private Client Services in Midland, Tex., believes the economic recovery will be protracted, with plenty of data along the way to "test our resolve as investors." The June payroll number was one pitfall, "not so much the report itself but how long before those people go back to work," says Cargile. "The longer people stay unemployed, that's when it will trickle down to earnings," by keeping a lid on consumer spending while driving up foreclosures. Cargile thinks unemployment will peak sometime within the next six months but he expects the subsequent decline in the jobless rate to be a slow process.

Certainly, additional job losses and higher unemployment won't be good news for bank earnings any time soon. Unemployed people will try to live off their credit cards for a short time after losing jobs, which should lead to continuing increases in credit-card charge-offs by banks, says Jaime Peters, a bank analyst at Morningstar Funds (MORN) in Chicago. For all the incentives the government is providing to compel mortgage servicers to restructure loans, "if the reason a person can't pay the loan is they lost their job, no modification is going to work. They'll be foreclosed on," she says.

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